The Dynamics of Firms' Credit Ratings
This paper analyzes the dynamics of firms' credit ratings, in the context of a multi-period moral hazard problem, in which borrowers have incentives to repudiate their debt obligations. Borrowers with short credit histories face the poorest incentives, and (depending on initial conditions) for these borrowers debt repayment can only be enforced by the threat of liquidation. However, over time if borrowers repay debt on all dates, they will establish a good credit history. This may improve their incentives, such that they will repay debt because they are concerned about their reputations for being a good credit risk, even if they face no threat of liquidation if they do default. The model generates predictions which explain two stylized observations on the dynamics of firms' credit ratings.
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